We should distrust how markets move initially in response to dramatic news.
Narratives emerge spontaneously amidst the huge new uncertainty. One of these becomes quickly dominant in the marketplace. That early dominance does not mean staying power nor even more importantly correctness. Sometimes the initial snapshot of future reality taken by the market proves to be highly erroneous. Most likely that is now the situation with respect to how the dollar reacted to the US election outcome as it emerged – falling broadly against the European currencies, the Canadian/Australian dollars and the yen.
The dominant narrative: divided US government (Republicans likely maintaining control of the Senate – though two run-off votes in Georgia in early January could bring effective Democratic control) means no further big fiscal stimulus ahead and so the Federal Reserve will pursue an even more radically easy monetary policy than previously assumed. The Pavlovian market reaction: dollar medium and long-term rates down, gold up, the dollar down, stock market led by the monopoly rent earners up. Problem: is it plausible that Fed policy gets any more radical than under President Trump?
After all, a top aim of President Trump from day one in the White House was the sustaining of a stock market boom and more generally asset price inflation. During the election campaign of 2016 he had accused the Fed under Chief Yellen of having stoked up a bubble for the purpose of getting Hilary Clinton elected. But once in power he swung to backing her policies and then outdoing them by appointing Jerome Powell, a private equity baron turned Fed insider, in her place (at term end in early 2018), as recommended by his Wall Street insider Treasury Secretary Steven Mnuchin. He doubled up by appointing a Bernanke-ite neo-Keynesian, Professor Richard Clarida, to the position of Fed Vice-Chair.
The stock market policy of President Trump is tottering on the edge of bankruptcy, even though it has been a fantastic week for the rollers of the dice on Wall Street. At the level of political strategy, the policy has already failed. In the mid-term elections of 2018, the Republicans lost the House to the Democrats. Now, in 2020, the policy did not prevent the Republicans losing the White House and preserving at best a wafer-thin majority in the Senate. President-elect Biden has other reasons not to follow the Trumpian stock market policy. The chances of asset inflation continuing without serious break into a third presidential term (after Obama 2013-16 and Trump 2017-20) is surely small. It could be better to allow the bubble to burst and blame it all on President Trump rather than to keep it going for some time with an almost inevitable crash further ahead into his Administration.
Bottom line: Fed policy may turn out to be somewhat less radical under Biden than under Trump. The next President will have a chance to put his stamp on this when he appoints a successor as Fed Chair to Powell whose terms ends in January 2022. There is absolutely no expectation of course that Biden would pick a sound money advocate for this post rather than a trucker of present soft money orthodoxy built around the so-called 2 per cent inflation standard. Within that constraint, however, there is a span of choices from most radical and Wall Street friendly to the least.
It is not fantastical to think that sound money might filter into the political mainstream again as the Republicans find their way forward from the end of the Trump presidency, taking advantage of their remarkably strong position in Congress. There is a chance of new ideological steps aimed at building a conservative alliance based on principled ideas. These might include a role for sound money, a cause almost totally deserted by the Republicans during the Trump presidency.
A re-building of sound money forces in Congress (albeit at first only amongst the Republicans) would have an influence on Fed politics. In any event, there is no possibility of the Fed following the European example of negative interest rates without a change in the Federal Reserve Act. This would require a filibuster proof majority in the Senate, not available even if the Democrats take control of the Senate following the Georgia run-offs.
Speculation on monetary regime adaptation in the US is certainly premature as a matter of near-term market reality. The big news around the Fed early on in the new Administration is likely to be its role in soothing a global credit and banking crisis. This would erupt as pandemic recession continues around the globe. It remains a mystery who holds all the increasingly dud collateral across so much of the world economy. The probability is high that at some stage there will be a run on equities and bonds of highly exposed banks, with the epicentre most likely in Europe.
In that situation there could be a powerful rise of the dollar against the European currencies. The yen is a different story. Japanese investors have been besotted with European assets, buying heavily into the higher yielding sovereign bonds there, and also with high-yielding US dollar bonds. In any crisis we should expect a reversal of such demand to go along with a stronger yen. A Biden Administration will be much less tolerant of Japanese currency manipulation than would have been the case under the Abe-Trump special relationship. Tokyo’s currency manipulation amounts to much more than slightly negative rates; the elephant in the room is the Bank of Japan’s massive holdings of foreign exchange reserves – built up during past periods of “disorderly markets” but never run down during the much longer “orderly markets”.
Back to the big picture for the dollar: the US economy is down around 4 per cent this year, a much milder fall than what we have seen in Europe, even for Germany. Europe has yet to face the political tumult which the pandemic could produce. The US has emerged in some respects already from that test. With Biden in the White House and the Republicans and Democrats evenly balanced in Congress, the dollar is not a bad place to be overall taking account of the known unknowns in Europe.